Treasury Inflation Protected Securities (TIPS) is a form of Treasury security that is issued through the U.S. government. TIPS are adjusted to inflation to safeguard the investors from a decrease in the buying power of their funds.
When inflation increases instead of their yield rising, TIPS instead adjust in their price (principal amount) in order to preserve their true value.
Understanding Treasury Inflation Protected Securities (TIPS)
The primary benefit of TIPS is increased with inflation. Inflation is the rate of price increases across in the U.S. economy, as determined through the Consumer Price Index (CPI). Inflation becomes a concern when there isn’t an equivalent increase in real wage growth to counteract the negative impact of inflationary costs. 1
TIPS are an asset that is popular to use for safeguarding the portfolio from inflation and also making money from it since they pay an interest rate every six months with a fixed rate set at the time of the auction. However, the payment amounts may differ as the rate is calculated based on the adjusted principal amount or price of the bond. In the event that the principle amount gets increased in the course of time due to rising prices or inflation, this rates of interest is multiplied by the higher principal amount. This means that investors are rewarded with higher coupons or interest payments when inflation increases. However, investors will be receiving less interest in the event of deflation. 1
TIPS have maturity dates of 5, 10 or 30 years. They are considered to be low-risk investments due to the fact that it is the U.S. government backs them. When the TIPs mature, they refund the principal adjusted or the original principal which is the greater amount. 1
TIPS can be bought directly from the federal government through Treasury-direct. direct Treasury system. They are available in increments of $100 with the minimum investment of $100. They are available in 5- 10, 10-, and 30-year maturity. 1
Certain investors prefer getting TIPS by purchasing the TIPS mutual fund, or an exchange-traded funds (ETF). The purchase of TIPS in the direct manner, however, permits investors to stay clear of the fees for management that are associated with mutual funds.
The Price Relationship of TIPS to Inflation
TIPS are essential because they reduce the risk of inflation which can reduce the yield of fixed-rate bonds. Risk of inflation is a problem since the interest rate for most bonds is fixed for the duration that the bond. In the end, the bonds’ interest payments may not be able to keep pace with the rate of inflation. For instance, if the prices rise by 3percent and the bond of an investor pays 2percent, the bond is losing money in real in terms.
They are intended to shield investors from the negative effects of price increases throughout the duration of the bonds. The par value–principal–increases with inflation and decreases with deflation, as measured by the CPI. When TIPS reach maturity holders receive the principal adjusted for inflation or the principal at the time of purchase which is the greater amount. 1
Imagine that an investor owns $1,000 worth of TIPS at the time of the year’s end, with an interest rate of 1percent. If there’s no inflation as measured by CPI the investor will receive 10 in coupon payments for the year. If inflation is increased by 2 percent the principal amount of $1,000 will be adjusted up by 2%, resulting in $1,020. The coupon rate remains identical at 1 percent however, it is multiplied by the modified principal of $1,020 in order to get an interest rate of $10.20 for the entire year.
If inflation was negative, also known as deflation, and prices falling by 5 percent, the principal amount is adjusted down to $950. The interest rate will be $9.50 throughout the year. But, at the end of the year the investor would get at least the principal amount at $1,000, or an increased amount, depending on the case. 1
The interest payment over the term of the bond can be calculated on a lesser principal in the event that inflation occurs however, the investor isn’t in danger of losing their principal in the first place if they hold it to completion. If TIPS are sold prior to their expiration date on an auction, they may be able to receive less than their initial amount of principal. 1
How to Purchase TIPS
Like similar Treasury security, buyers are able to purchase TIPS directly from the U.S. government at the Treasury website TreasuryDirect.gov. It is a tad complicated login procedure with multiple protection layers. 3
You can also purchase treasury inflation protected securities from your bank or broker. This is a good option for investors who have a large portfolio of securities held by the same financial institution.
The advantages and disadvantages of TIPS
While TIPS may be an appealing option for investors expecting an increase in inflation, they’re the disadvantage of other kinds of debt in times of normal inflation. Here are some additional considerations to take into consideration:
- lower yield: They typically pay higher interest rates than other types of government or company securities which means they’re not always the best choice for those who invest in income. They are a good choice for the protection against inflation, however, when inflation is low or not present, their value reduces.
- Tax Aspects: Like other Treasury bonds that are backed by inflation and interest, the interest adjustments of TIPS is exempted from local and state income tax. However this inflation-related adjustment can be classified as tax-deductible by the IRS however, the investors do not see that amount till they decide to sell their bond or when it matures. 4 Some investors keep TIPS in retirement accounts with tax-deferred status to avoid tax issues. However, it could be worthwhile to consult an expert in tax to discuss the tax consequences that investing into TIPS.
What yields do TIPS have?
The yields of TIPS are usually typically negative. This is because when you take into account inflation effects and the effects of inflation, it is evident that the true yield is negative. In the example above the regular 2-year Treasuries are yielding 1% and inflation is 2percent so the real yield is minus 1 percent. TIPS are designed to keep pace to inflation and not bring down it and, therefore, you can get an nominal return for TIPS, which can be positive , but an actual yield that is actually zero. While the yield of TIPS could have negative values, their main value will rise with inflation and can result in capital gains.
Why does the Treasury issue TIPS?
TIPS first came out in 1997. The official reason for their introduction is the fact that there was a an overwhelming demand from the investment public for securities linked to inflation. 9 Some economists are puzzled about the continuing issuance by the government of TIPS, as they are believed to represent a more expensive option to borrow than conventional Treasuries. 10
What maturities do Treasury TIPS Have?
The initial TIPS were set to 20 years of maturity. In 2009, TIPS that were 20 years old were canceled in favor of TIPS with a 30-year maturity. In the U.S. Treasury, U.S. Treasury presently issues 5-year, 10-year as well as 30-year treasury inflation protected securities.
